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Variable rate programs: Are you ready for the rate changes?

May 05, 2022

With the ongoing COVID-19 pandemic and a government trying to battle inflation, it’s likely the U.S. will see multiple rate increases throughout 2022. Already on March 16, 2022, the U.S. Prime Rate adjusted to 3.5%, which was the first adjustment in two years.

The increased income for your financial institution is the positive outcome of these increases, but if you don’t have appropriate controls in place for your loans with variable rate terms, you may find yourself in hot water with consumers and regulators.

Let’s take a look at some key controls to review for your variable rate products to set your financial institution up for success.

HELOC and consumer open-end lines of credit

Many financial institutions have lines of credit they offer to consumers, both unsecured and those secured by residential real estate. Your loan agreement executed with the consumer drives how and when rate changes will occur. The agreement should identify how the variable rate functions (typically through use of an index plus a margin), the frequency of rate changes and any limitations to rate changes, such as a lifetime cap or subsequent rate limitations. The index used by your financial institution should be stated in the loan agreement along with an outside source the consumer can inquire to confirm the current index rate.

You may be thinking, this all sounds standard, and you use vendor-vetted loan agreements, so what could go wrong?

System parameters can make or break a successful rate change that is due to occur. At the time of loan origination, key features of the loan product are set in the system that will drive the rate changes. It’s important to set up the individual loan correctly to avoid potential consumer harm.

Control considerations

Regardless of the variable rate product type, there are steps your financial institution can take to have confidence that rate changes occur consistent with the loan agreement. Your financial institution should have a process in place to verify, at a minimum, the following controls and system settings are accurate:

  • Review your variable rate loan agreements: Confirm they disclose the index, margin, any maximum or minimum lifetime rate caps, any rate caps for each rate change, index lookback period, frequency of rate changes, and any rounding factors when determining the rate. You want to make sure the language in the agreement is consistent with management’s expectation of how the product should function and system parameters. For example, during the low-rate environment, some financial institutions thought their product had a floor rate when the loan agreement never specified a floor rate. The system parameters had a floor rate input and consumers were being assessed a higher rate than was specified in their loan agreement.
  • Verify there is an internal process to confirm the system parameters set for the individual loan: Don’t assume accuracy from a product level. The individual loan may have had a change to the margin or timing of the rate change, and if you do not validate the loan agreement and system parameters are consistent, you may run into unintended consequences.
  • Test a sample of rate changes that occurred to confirm the changes are occurring consistent with the loan agreement: If the agreement states the rate will change on the first business day of the month, confirm the change is occurring on the first business day and not the first calendar day or the day of the index change.
  • Confirm any required notices provided to the consumer include accurate information: If the notice includes reference to the source of the index, the index, the margin or any rate limitations, verify the reference is consistent with the loan agreement
  • Ensure when rate indices are updated in your system that the correct index is being entered: For example, if your loan agreement states the rate will vary with the weekly average U.S. Treasury index with a constant maturity of one year, you enter the weekly average index rather than the daily index.

These considerations are not all inclusive. Software or system updates can cause unintended consequences to data fields. Follow up after a software or system update to confirm no unintended data fields were changed that were not expected.

For example, the software update may have inadvertently defaulted the rate change date field back to the default rate set in the system. It’s important to recognize that even when you expect everything to function as it should, software updates, employee changes and data input errors can all contribute to unexpected or unintended changes.

Adjustable-rate mortgages (ARMs)

ARMs are another product type offered by financial institutions that you can easily apply the prior control considerations to as well.

Consumer ARMs also require initial and final rate change notifications under Regulation Z. In addition to the controls identified above, these notices are required to be provided at specific intervals. The initial ARM rate change notice must be provided for the first contracted rate adjustment at least 210 but not more than 240 days before first payment at adjusted level is due. The subsequent notice must be sent at least 60 but not more than 120 days before first payment at adjusted level is due.

The timing of these notices again ties back to your data fields set in the system for a specific loan. If you have the incorrect initial rate change date in the system, the notice will not generate within the required timeframe.

If you have not already, now is the time to validate your variable rate products are functioning as they are intended. Financial institutions have been fortunate with low and non-volatile interest rates in the last decade, but rapid change without proper controls can cause chaos. Practices resulting in consumer harm are the hot buttons for regulators and the media in today’s environment. Take a proactive approach in verifying your product settings so you don’t have to spend time on the backend notifying and reimbursing consumers for preventable actions.

How Wipfli can help

Wipfli performs both compliance audits with scopes that can include rate change notice and system parameter testing, as well as consulting engagements to specifically meet your needs. If you’re looking for validation that your rate changes and any applicable notices are accurate, our compliance consultants can provide the support you need. At the completion of our review, we provide a list of errors and discrepancies for you and recommendations for corrections to be made.

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Erica Dornfeld
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